Managing Financial Resources and Decisions - Assignment Example

Task Financial ments:- Financial ments are formal accounting reports that record the financial effect of the business transactions on the entity. These are the primary source by which management communicates company’s financial results to its stakeholders. Types of Financial Statements:- There are basically four main types of financial statements named as Income statement, Balance Sheet, Statement of owner’s equity and statement of cash flow. All of these are briefly explained in following, 1. Income Statement:- Income statement also known as “Profit and loss account”, “Statement of earnings” and “Statement of operations” represents the financial results of a company in terms of profit and loss. It summarizes all of the revenue and expense items of the firm and presents the final result in term of profit and loss, for a given period of time. 2. Balance Sheet:- Balance sheet presents the financial position of a firm at a given point in time. “The statement balances the firm’s assets (what it owns) against its financing, which can be either debt(what it owes) or equity ( what provided by owners).[GITMAN 2006] 3. Statement of Owner’s Equity:- It summarizes all of the changes that occurred in the owner’s equity during the given period of time. 4. Statement of Cash Flow:- Statement of cash flow record the movement in cash and bank balances of the firm resulting from operating, financing and investing activities. Link between Different Financial Statements:- All of the above mentioned financial statements are inter dependent and inter linked, their link is shown in following diagram by Accounting-simplified.com [http://accounting-simplified.com/financial/statements/types.html] Purpose of Financial Statements:- Financial statements are prepared to present and record information regarding the financial position of a firm at a given point in time, to show performance of the firm during the particular period, and to depict changes in performance during that period. This information is used by the different users of financial statements to make their decisions. Users of Financial Statements:- Following is a list of users of financial statements and the information which they get. User Information 1 Managers Assessing performance for managerial decision making 2 Creditors Check credit worthiness for granting credits. 3 Investors For assessing profitability for making investment decision. 4 Shareholders To assess risk and return and profitability. 5 Employees Assess profitability and its prospective effect on their benefits. 6 Competitors For competitive intelligence and find best practices. 7 Suppliers Assess credit worthiness to grant credit lines. 8 Customers To assess stability and standing for ensuring safe supply lines. 9 Government For tax purposes. 10 General Public Assess effect on economy and general public. Limitations of Financial Statements:- 1. Different accounting policies:- Use of different accounting policies as GAAP and IFRS by different firms effects comparability of the financial statements. 2. Accounting estimates:- Sometimes estimates have also to use in preparation of financial statements which reduces reliability. 3. Historical Information:- Financial statements are based on historical data and do not present the current financial position and worth of the entity. 4. Historical Cost:- Accounting statements record the assets at their historical cost and hence do not exhibit the current value unless the asset is revalued or disposed off. 5. Impact of Inflation:- Financial statements do not account for the impact of inflation hence “Cannot be a true reflection of growth where the economy is infected with a high level of inflation”. [IBP 2011] 6. Fraud and Error:- Financial statements are vulnerable to frauds and errors e.g. window dressing which makes their credibility and reliability doubtful. 7. Measurability:- Financial statements only record the information that is measureable and do not account for qualitative characteristics and assets and efficiency, competence of workforce and goodwill etc. 8. Cost benefit compromise:- Sometimes quality of accounting information is compromised due to cost factor, which reduces its reliability. Task 2 Sources of Financing There are different long and short term and internal and external sources of financing available to “Paul and Sarah” to finance their expansion. These sources are briefly discussed in following. 1. Personal Savings:- Investing personal savings of the partners is one of most simple, cost effective and suitable option available to Paul and Sarah’s. Moreover another benefit of using this option according to Boyneclarke .com is that “you relinquish no control over your business.” [http://www.boyneclarke.com/ resources/entry/sources-of-business-financing] so investing personal savings will also secure control of the partners on their business and will result in avoiding many managerial and regulatory complexities. Both of the partners Paul and Sarah can invest their personal savings at any agreed ratio into the business to finance its expansion. 2. Business Partners:- Adding one or more other partners into the business is also one of the available options to Paul and Sarah’s. They can add new partners into their business who can provide required financing, moreover if they succeed in adding a competent business partner then it can not only provide financing but also can provide business acumen and can help in administration. 3. Retained Earnings:- Retained earnings are also one of the best source of financing business expansion, so Paul and Sarah’s should also invest their retained earnings for the recent expansion. 4. Venture Capital:- Venture capital is equity investment into the firm by any venture capital organization. As it is an equity investment so entails high risk, so venture capital organizations require high expected rate of return on their investment, as compensation of taking high risk. Paul and Sarah’s may also go to any venture capital bank or organization to satisfy their existing financing needs. 5. Franchising:- Another most effective technique that Paul and Sarah’s can use is franchising, as in this the way that can expand their operations without any remarkable investment “it is an alternative to raising extra capital for growth” [http://www.fao.org/docrep/W4343E/w4343e08.htm] But it must also be kept in mind that this technique may create some quality and services related problems so proper policies must be formulated and trainings conducted to align the quality and service standards of the franchises to the existing standards of the firm which are its USPs. 6. Bank Loans:- Banks offer a number of financing products to meet firms short, medium and long term financing needs. So Paul and Sarah’s may also obtain funding from the banks in the form of term loan, mortgage and overdraft. 7. Leasing:- The firm may also lease multiple items and facilities for new franchises. 8. Government Sources:- Governments also provide loans and assistance for business and industry development so it may also be a source used. 9. Going Public:- Most recommended, reasonable and effective technique in this scenario for the Paul and Sarah’s is of going public. As firm has now matured in the market and has become stable, so it offers marvelous opportunities for growth. The firm should capitalize on these opportunities by expanding its network and strengthening its legal status. It is the very right time for the firm for going public. So firm must make an IPO and go public in this way it will not only be able to meet its existing financing needs but will also be easily able to satisfy such needs in future by issuance of common and preferred stock and bonds and debentures. Moreover it will also enhance the corporate status and image of the firm. Costs of Financing:- Below diagram shows the cost of financing which firm will have to pay to type of lenders for the risk taken by them. [http://www1.agric.gov.ab.ca/$department/deptdocs.nsf/all/apa2328] Task 3 Net Present Value:- “NPV of an investment proposal is the present value of the proposal’s net cash flows less the proposal’s initial cash outflow”. [JAMES & JOHN 2000] its Formula is NPV= CF1/ (1+k) 1 +CF 2 /(1+k)2+…..+CF n /(1+k)n -ICO Decision criteria for the NPV is to accept the project if NPV is positive and to reject the project if NPV is negative. As NPV of the investment of Diabolic Sounds Limited is £47000 which is possible so firm should undertake this project. Pay Back Period:- “Time until cash flows recover the initial investment in the project”. [BREALEY, MYERS & MARCUS 2007] Decision rule for the payback period is that a project should be accepted only if its payback period is less than a specified cutoff period. Payback period of the investment of Diabolic Sounds Limited is 3 years and 10 months, but we are not provided with the information regarding cutoff period of Diabolic Sounds nor about the useful life of the machinery so our decision will be based on our intuition as machinery is a long term asset and payback period of about 4 years is a good deal so project should be accepted. Internal Rate of Return:- “The discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero”. [http://www.investopedia.com/terms/i/irr.asp#axzz2FICA0Tb8] This relationship of IRR with NPV is also shown in this diagram.Following is the equation for calculation of IRR. CF0= ∑t-1 CFt/(1+IRR)t Decision criteria for IRR is to accept the project if IRR is greater than cost of capital and reject if IRR is less than cost of capital. As we are not provided with the cost of capital information in the case of Diabolic Sounds so it is not possible to make the decision in the absence of the standard. Weaknesses of NPV IRR and Payback period:- NPV IRR Payback Period Expressed in terms of dollars not percentage. An estimate of cost of capital is required to calculate NPV. Not as effective to compare mutually exclusive projects. Assumes all cash flows reinvested at the IRR. Requires an estimate of the cost of capital to make decision. Does not account for time value of money. Do not consider the cash flows beyond the payback period. Ignores the risk to future cash flows. References GITMAN, J. LAWRENCE. 2006, Principals of Managerial Finance 11th edn. pg.49, Pearson Addison Wesley. Accounting-Simplified.com, Accessed on 16 December 2012. < http://accounting-simplified.com/financial/statements/types.html> IBP.2011, Accounting for Financial Services, pg.31, The Institute of Bankers Pakistan, Karachi, Pakistan. Boyneclarke.com, Accessed on 17 December 2012. FAO Corporate Document Repository, Accessed on 17 December 2012. ˂ http://www.fao.org/docrep/W4343E/w4343e08.htm ˃ Alberta.ca, Accessed on 17 December 2012. ˂ http://www1.agric.gov.ab.ca/$department/deptdocs.nsf/all/apa2328˃ JAMES C. VAN HORNE & JOHN M. WACHOWICZ, JR.2000, Fundamentals of Financial Management 10th edn. Pg.329, National Book Foundation Islamabad, Pakistan. BREALEY A. RICHARD, MYERS C. STEWART & MARCUS J. ALAN, Fundamentals of Corporate Finance, 5th edn. Pg.187, McGraw-Hill Irwin Newyork, USA. Investopedia.com, Accessed on 17 December 2012. ˂ http://www.investopedia.com/terms/i/irr.asp#axzz2FICA0Tb8˃ The Engineering Tool Box, Accessed on 17 December 2012. ˂ http://www.engineeringtoolbox.com/internal-rate-of-return-irr-d_1235.html˃ Read More